Prime costs represents the total costs directly involved in manufacturing a product. This lesson breaks down the components of prime costs, its formula, and how it is used.
Mia is an up-and-coming fashion designer. After being featured in a community fashion show, Mia received a large order from a local boutique for some of her pieces. Due to the size of the order, Mia knows that she will have to buy extra fabric and hire outside help.
The business expense of purchasing materials and paying laborers to actually manufacture the product are the direct costs that add up to the prime cost.
The Formula Breakdown
Calculating the prime cost is fairly simple. Just add the cost of raw materials together with the cost of direct labor, and viola, you have the prime cost:
Prime Cost = Raw Materials + Direct Labor
The boutique ordered 25 skirts, 35 blouses, and 50 dresses. To fill the order, Mia heads to the fabric store to purchase material to fill the order. This cost is the raw materials cost, as fabric will be needed to make the pieces for the boutique's order. Mia also recruits her two best friends, Lisa and Nadia, and agrees to pay them each $30 an hour for their help in sewing each piece. This is a direct labor cost because Lisa and Nadia will be working directly with the materials purchased to create the pieces needed to satisfy the boutique's order.
Now, let's crunch some numbers!
Applying Numbers to the Formula
Mia spent $500 on the fabric needed to make all 25 skirts, and it takes the ladies five hours to finish them. The prime cost would equal $650.
Prime Cost = ($500) + ($30 * 5)
PC = $500 + $150
PC = $650
After spending $750 on material and ten hours of labor to make the 35 blouses, what is the prime cost?
Prime Cost = ($750) + ($30 * 10)
PC = $750 + $300
PC = $1,050
The prime cost for 35 blouses is $1,050.
Finally, Mia spends $1,250 to purchase enough material to make 50 dresses, and it takes Mia, Lisa, and Nadia a total of 25 hours to complete them all.
Prime Cost = ($1,250) + ($30 * 25)
PC = $1,250 + $750
PC = $2,000
The prime cost for 50 dresses is $2,000.
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Knowing the prime cost can help measure production costs. Monitoring the cost of production can help businesses lower costs to increase profits. If Mia's raw material expense is usually high, she may be able to purchase more fabric when it goes on sale to minimize the amount spent on raw materials for future projects, thus lowering the cost of production. Calculating the prime cost can also project the price a business must charge in order to make a profit, or at least break even.
Mia spent a total of $650 manufacturing 25 skirts. That means she spent $26 to make each skirt ($650 / 25 dresses = $26) and must charge at least $26 to cover her expenses. Mia can use this information to decide how much over $26 she will charge in order to make a profit. The blouses cost a total of $1,050 to produce; therefore, Mia must charge over $30 ($1,050 / 35 dresses = $30) to ensure a profit. Given the amount Mia spent on making 50 dresses, what is her break-even price?
$2,000 / 50 dresses = $40
Mia must set the price of each dress over $40 to make a profit.
Prime cost paints a picture of what it costs to produce an item by adding the cost of raw materials to the cost of direct labor needed to actually create that product. Once the prime cost is known, it can be used to manage production costs and help determine a break-even price that tells businesses what price has to be set in order to cover expenses and make a profit.
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